Introduction to Option Strategies in Real Estate

December 21, 2015

One of most prolific and powerful tools of “creative” finance in real estate is the lease-option, but this tool represents only the proverbial tip of the iceberg when it comes to the most powerful breed of derivatives in the investing world, options. There are two basic types of options: the call option (or “call”) and the put option (or “put”). A call is what is utilized in the traditional lease-option; the put, on the other hand, is virtually unheard of in the world or real estate. An option, call or put, can be used as a standalone contract or in various combinations simultaneously to bet on any potential outcome. In other words, option strategies can be structured to profit from a property rising in value, falling in value, not changing in value, or simply by its value just moving… up or down. While options strategies are considered basic knowledge for financial professionals, they are hardly understood by real estate investors and agents, and herein lies the opportunity. In an effort to help expand their market within the real estate investing community (which will improve its overall liquidity), this article will attempt to briefly explain what options are and impart a basic understanding how they can be utilized:

Derivatives

In simple terms, a derivative is any contract that derives its value from the asset that it’s written on, or underlying asset. Futures/forwards contracts, options and swaps are the most common types of derivatives. One simple example of a derivative is a purchase contract on a house, which would be referred to as a futures or forward contract in the world of finance. If a house has a current market value of $500k and the purchase contract has a sale price of $450k, then the purchase contract has a potential value of $50k. Of course there are many considerations that affect the value of the purchase contract such as the method/accuracy of estimated market value of the underlying house, term (time left to close), and perceived strength of the buyer; but regardless, both in theory and in practice, the assignable real estate purchase contract is a derivative that can be sold (i.e. assigned) in the open market to another party for a fee.

Call Option

A call option is an agreement in which an investor pays someone else, a counterparty, for the right, but not the obligation, to buy something (i.e. underlying asset) at a specified price within a specific time period, or term. This payment is called an option fee, consideration or premium. It may help to remember that a call option gives an investor the right to “call in” (buy) an asset. Investors profit on a call when the underlying asset increases in price. A call option is said to be in the money when the purchase price of the underlying asset, or strike price, is below the market price of the underlying asset (plus the option fee if it is not credited to the strike price); the call is out of the money when its strike price is above the market value (again, plus the option fee if it is not credited to the strike price). In the case of the lease-option (which is two separate agreements: a lease and a call) investors are generally banking on either the underlying property appreciating during the term of the option or they believe they have negotiated a strike price that is below current market value with no expectation of the property falling in value, or depreciating, during the option term. It’s worth noting that the lease is not necessary to benefit from the value of the option.

Put Option

A put option is the opposite of a call where the owner of an underlying asset pays an option fee to a counterparty for the right, but not the obligation, to sell the asset at a specified price within a specified time. A put option is said to be in the money when the strike price is above the market price of the underlying asset (minus the option fee if it is not credited to the strike price), and out of the money when its strike price is below the market price (again, minus the option fee if it is not credited to the strike price). A put becomes valuable as the price of the underlying asset falls, or depreciates, relative to the strike price. For example, if an investor buys a put option on a property for $500k with a term of two years, he has the right to sell is house for $500k at any time during that two-year period to the counterparty of his put. An investor might do this is he thinks the market might crash during the put option term or if he believes he overpaid for the property. Put options can act as a form of insurance against a depreciating asset or crashing market.

Long and Short Option Positions

For each of these two types of options, an investor can take either side of the contract, the long or the short position: In the case of call options, a long position is the right to buy (call) the underlying asset. For the long call holder, the payoff is positive if the asset’s price exceeds the strike price by more than the premium paid for the call. Short call holders believe an asset’s price will decrease; they are said to sell or write a call. If an investor sells a call, holding a short position, he gives up the control to the buyer of the call (the long call) who determines whether the option will be exercised. For the writer of the call, the payoff is equal to the premium received from the buyer of the call if the asset’s price declines, but if the asset rises more than the strike price plus the premium, then the writer will lose money.

Like a short call position, long put holders believe an asset’s price will decrease and buy the right (long) to sell (put) the underlying asset. As the long put holder, the payoff is positive if the asset’s price is below the strike price by more than the premium paid for the put. Short put holders believe the asset’s price will increase and sell or write a put. For the writer of the put, the payoff is equal to the premium received by the buyer of the put if the asset price rises, but if the asset price falls below the strike price minus the premium, then the writer will lose money.

The Straddle and Other Simultaneous Options

While options can be used to generate returns based on an expectation that an asset’s price will move in a particular direction, they can also be used to generate returns based upon an expectation of whether an asset’s price will simply move at all, i.e. experience volatility. A straddle is an investment strategy involving the purchase or sale of a put and call option at the same time on a single asset with the same strike price and term; this allows the holder to profit based on how much the price of the underlying security moves, regardless of the direction of price movement. The purchase of the call-put pair is known as a long straddle and profits are made from significant price movement up or down insofar as the price of the underlying asset increases or decreases more than the amount of the option fees paid. The sale of the put-call pair is known as a short straddle and profits are made from stagnant pricing as the owner of the short straddle collects option fees for both the put and the call when neither will be exercised. It is worth noting that options can be used in many various combinations and to accomplish any number of hedging strategies.

Options and Real Estate

Option strategies represent a relatively inexpensive, low-risk approach to betting on any possible outcome an asset may experience; all that is needed is another party with the conviction to put their money up in support of the opposing view. Real estate brokers are perfectly positioned to match such counterparties and to establish real estate derivatives as a liquid investment market.

The unique advantage of real estate as compared to traditional financial assets is that hardly anyone in the residential market has any idea how to price and value options. It is common practice for real estate owners to charge disproportionately small option fees for the right to buy their property at a given price (especially when a call is paired with a lease), which affords real estate investors the unique opportunity to recognize substantial upside potential while incurring hardly any risk. This disproportionate, or asymmetric, risk-reward profile (i.e. convexity) is the ultimate goal for professional investors.